Fed's Inflation Concern Broadens Easing Rationale

The Federal Reserve moved closer to a second wave of unconventional monetary easing and said for the first time that too-low inflation, in addition to sluggish growth, would warrant taking action.

The Federal Open Market Committee’s statement yesterday that inflation is “somewhat below” levels consistent with its congressional mandate for stable prices pushed yields on two-year Treasuries to a record low. The language evoked FOMC warnings in 2003 of the risk of inflation “becoming undesirably low” that justified the era’s low-rate policy.

The move by Chairman Ben Bernanke, 56, who was a chief advocate of the 2003 stance, positions the Fed for expanding a near-record $2.3 trillion balance sheet as soon as November. Inflation that’s too low could result in higher real interest rates and further slow the economy while increasing chances of deflation, or a broad-based decline in prices, said Mark Gertler, a New York University economist.

“The language on inflation is a pretty clear message that they’re going to do something” and purchase more securities, said John Canally, an investment strategist and economist at LPL Financial Corp., which oversees $276.9 billion in Boston.

“The question that will be repeatedly asked over the next six weeks in the markets is, ‘How much are they going to do and will it work?’” Canally said, referring to the FOMC’s next meeting Nov. 2-3.

The FOMC said in its statement that it’s “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

Bank of England

In London, the Bank of England signaled that policy makers are moving closer to adding more stimulus to the economy. The BOE’s Monetary Policy Committee voted 8-1 to keep the benchmark interest rate at 0.5 percent and the bond-purchase plan at 200 billion pounds ($313 billion).

While Andrew Sentance pushed for a fourth month to raise the rate “gradually,” “most” officials see the central bank’s current stance as “appropriate,” according to minutes of the Sept. 9 meeting released by the central bank today.

Dollar Falls

The dollar slid to the lowest in almost five months versus the euro on speculation the Fed’s willingness to ease monetary policy further will damp demand for U.S. assets. The dollar dropped to $1.3356 per euro as of 10:40 a.m. in London from $1.3264 yesterday in New York, after reaching $1.3382, the weakest since April 27. The greenback fell to 84.6 yen from 85.09 yen.

Gold climbed to a record in London and New York. Bullion for immediate-delivery rose $4.75, or 0.4 percent, to $1,291.90 an ounce in London at 10:31 a.m., after earlier today rising to a record $1,295.

Treasuries rose for a fourth day. The 10-year note yield dropped 4 basis points to 2.54 percent as of 6:40 a.m. in New York, according to BGCantor Market Data. The Standard & Poor’s 500 Index slipped 0.3 percent to 1,131.10 at 7:23 a.m. New York time, retreating from a four-month high.

The Fed yesterday retained its policy, begun last month, of reinvesting proceeds from the repayment of mortgage debt into long-term Treasuries. The committee also kept the benchmark federal funds rate in a range of zero to 0.25 percent, where it’s been since December 2008, and reiterated that the rate will stay “exceptionally low” for an “extended period.”

The Fed’s previous statement, from Aug. 10, said the Fed would “employ its policy tools as necessary to promote economic recovery and price stability.”

Fed Directive

The statement didn’t say what level of inflation would be consistent with the Federal Reserve Act’s directive for “maximum employment, stable prices, and moderate long-term interest rates.” Fed officials indicated at their June meeting that they prefer long-run inflation ranging from about 1.7 percent to 2 percent. That’s based on the Commerce Department’s personal consumption expenditures price index.

“They made it very clear they’re not happy with current inflation rates,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut, and a former Fed researcher. “That gives an intellectual underpinning as to why they might do” quantitative easing, or large-scale asset purchases, he said.

Market-based measures of inflation expectations rose following the Fed’s announcement. Expectations for inflation in five years, derived from yields on Treasury Inflation Protected Securities and nominal Treasuries, rose to 2.54 percent, the highest in three months, from 2.45 percent on Sept. 20.

Slowing Inflation

Bernanke, as a Fed governor at the August 2003 FOMC meeting, outlined his concerns about slowing inflation when the committee adopted the “undesirably low” language and held the overnight interbank lending rate target at 1 percent.

“Even if we consider actual deflation to be too remote to worry about, further disinflation poses important risks,” Bernanke said, according to transcripts released last year. “Disinflation offsets monetary policy ease already in the system, and very low inflation may limit the ability of monetary policy to respond by conventional means to future adverse shocks.”

Gertler, who’s collaborated on inflation research with Bernanke, said yesterday that “low inflation doesn’t bother them if they could keep it exactly where it is. It’s just that they’re that much closer to the red zone” of deflation.

Avoiding Deflation

Bernanke has researched avoiding deflation before and during his time at the central bank, “so that likely is informing some of his actions now,” said Dean Maki, Chief U.S. Economist at Barclays Capital Inc. in New York and a former Fed researcher.

From late 2008 through March 2010, Bernanke’s purchases of mortgage debt and Treasuries helped end the longest downturn since World War II without securing a recovery strong enough to reduce joblessness.

“They set the table” for more easing in yesterday’s statement, said former Fed Governor Lyle Gramley, now senior economic adviser with Potomac Research Group in Washington. “They need to see enough evidence that the economy is growing slowly so that the unemployment rate will start to move up.”

At the same time, the inflation language “provides for a basis for the committee acting even if the unemployment rate didn’t go up,” he said.

The Federal Reserve moved closer to a second wave of unconventional monetary easing and said for the first time that too-low inflation, in addition to sluggish growth, would warrant taking action.
The Federal Open Market Committee s statement yesterday that inflation is ...